1. Supply chain  Supply chain is a two or more parties linked by a flow of goods, information, and funds This section builds heavily on excellent review by Tsay et al (1999) Manufacturer Retailer c W(Q) p Q Min {Q, D(p)} Q D(p) Financial Material Information

2. Purpose of contracts  Total supply chain profits are maximized when all decisions are made by a single decision maker who has access to all available information (referred to as the first-best case, typically requires the central control of supply chain). Let  C denote the supply chain profits under this scheme.  However, generally, neither the manufacturer, nor the retailer has the control of the whole supply chain. Each has his own incentive and state of information (referred to as decentralized control). Let  D denote the total supply chain profits under this scheme.  Decentralized control is inefficient if  D <  C  How do you make the supply chain efficient and just?

3. Purpose of contracts  Risk-sharing: How to split  D between the two parties  Example: The retailer is required to submit forecast information to the manufacturer to make capacity and materials purchasing decisions  No commitment for retailer  Retailer may cancel orders if demand is low,  Retailer may deliberately inflate forecasts to insure supply  Too much risk for the manufacturer: how to design contracts so that manufacturer is protected against such risk  System-wide performance improvement: How to bring  D closer to  C (sometimes referred to as channel coordination)  Example: Double marginalization  Retailer buying at a price of t, selling at a price of p (a margin of p-t)  Manufacturer buying at a price of c, selling at a price of t (a margin of t-c)  Supply chain profits are maximized when a margin of p-c is used, when making a supply decision

4. Purpose of contracts  Long-term partnerships  Example: Intel might be willing to consign a large portion of its production of a new generation of microprocessors to a single OEM such as Dell  The microprocessor may sell for a higher price in open market  However, Intel’s motivation would be to build long term relationship in the hope that Dell would be a volume purchaser for years  Making the terms of the relationship explicit  Making each party’s expectations legally concrete  Lead times  On-time delivery rates  Product quality

5. Types of contracts A.Specification of decision rights B.Pricing C.Minimum purchase commitments D.Quantity flexibility E.Buyback or returns policies F.Allocation rules G.Lead time H.Quality

6. A- Specification of decision rights  Specifications of decision rights: Reassigning the control of the decision variables  Shifting the control from one party to the other  Eliminate double marginalization  Better informed party making the decision  Resale Price Maintenance (RPM): manufacturer deciding the sales price  Quantity Fixing (QF): manufacturer setting the order quantity for the retailer  Lee and Whang (1997)  Decentralized multi-echelon inventory system  If only most downstream level has a backlog cost, then that level would carry extra inventory  However inventory is most expensive at that level  How could you modify inventory holding and backlog costs at each level so that channel costs are minimized

7. B- Pricing and quantity discounts  Traditionally, wholesale price is fixed and is not subject to negotiation  How could we use wholesale price as a coordination mechanism?  A sufficient discount can induce the buyer to order a quantity that increases the supplier’s net profit  Optimizing wholesale unit price  Offering all units quantity discounts  Offering a linear discount schedule  Weng (1995)  How to implement a mechanism to divide the additional profits generated through channel coordination with quantity discounts?  A franchise fee plus quantity discounts will optimize profits of both parties

8. C- Minimum purchase commitments  Traditional inventory models assume that the buyer can order any quantity from the supplier at any time  However this is not desirable for the supplier  Bullwhip effect  Inefficient use of capacity (low at certain times, high at others)  Supplier either quotes a long lead time, or high wholesale price  One solution is an agreement in which the buyer agrees in advance to accept delivery of at least a certain quantity of stock, either in each individual order or cumulatively over some period of time.  The manufacturer offers some form of incentive  Lower unit cost on items purchased  Bassok and Anupindi (1997)  Minimum purchase quantity of K N over N periods  How much should the retailer purchase when he has a starting inventory level of I n and remaining commitment of K n  Result: a modified base stock policy is optimal

9. D- Quantity Flexibility  The quantity the retailer ultimately obtains may deviate from the initial order quantity under some conditions  Limits on the range of allowable changes  Pricing rules  There is a clear advantage to the retailer as it provides more flexibility  Retailer would be willing to pay more for its deviation from its initial order quantity  Questions  How should the contract be designed so that both parties are better off?  How should the retailer behave given the flexibility?  Initial ordering decision + a revision based on the sales information  How should the manufacturer behave given the flexibility?  Eppen and Iyer (1997) – backup agreements  The retailer commits to y units for the season  Initial ownership of (1-  ) y at the unit price c before the season  Order up to  y at the original price during the season  A penalty cost of b for any of the backup units not purchased

10. E- Buyback or returns policies  A buyback or return contract establishes who bears responsibility for unsold inventory and to what extent  Similar to Quantity Flexibility contracts except that buyback or returns take place after the whole demand is materialized  Types of return policies  Unlimited returns at full credit  Limited returns at full credit  Unlimited returns at partial credit  Pasternack (1985)  The manufacturer sets the wholesale price, market selling price is fixed, the retailer decides the order quantity  Inefficient mechanism because of double-marginalization  Policies that allows for unlimited returns at full credit or no returns are not inefficient  Channel coordination can be established using a policy that allows unlimited returns at partial credit  Wholesale and buyback prices can be set to guarantee Pareto improvement and these prices are independent of the market demand distribution.

11. F- Allocation rules  How to distribute manufacturer’s available stock or production capacity among multiple retailers in a shortage scenario  Possibility of rationing lead to strategic behavior and retailers tend to inflate their orders causing information distortion (Lee et al 1997)  Not enough research on how different allocation schemes may help to increase channel profits  Cachon and Lariviere (1997)  Even allocation: Allocate capacity evenly  Turn and earn: Allocate capacity based on past sales  More profitable for the supplier  May not be profitable for the retailers: they end up decreasing their prices to increase their sales to protect their allocation

12. G- Lead times  Manufacturer offering the retailer multiple choices for the lead time  Iyer and Bergen (1997)  Manufacturer offering a reduction in lead time through a Quick Response contract  Retailer benefits since it is ordering based on an improved state of information (with possible updating of demand distribution based on sales)  However the manufacturer may lose from reducing the lead time as it is unaffected from the overage risk  Manufacturer will prefer high retailer orders, even if this includes a large amount of safety stock that never get sold  Thus the manufacturer may resist efforts that will reduce lead time reductions  Lead time reduction efforts should be supported with other side agreements such as  Higher service levels to end customer, higher wholesale price, volume commitments

13. H- Quality  Production quality has a positive effect on both sales volume and production cost  Demand is increasing with quality and decreasing with price  What should be the quality of the product that will maximize channel profits?  Similar variables are advertising and service  Other issues  Who should inspect the material?  What is the frequency of inspections?